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Portfolio Management Update Fall 2023
Portfolio Management Update
The late-cycle phase with risks of a Federal Reserve (Fed) induced recession calls for an asset allocation strategy that addresses both slower economic growth and an eventual end to Fed rate hikes. A balanced strategy, investing in selective areas of the stock market and bond market, could provide more protection in case the economy does slip into a mild recession, and appreciation potential as the tightening cycle ends in a soft-landing economic scenario. Historically, S&P 500 index returns are usually positive after inflation peaks, and when inflation is range bond or declining based on an NDR study. The same can be said for areas of the bond markets. What’s more, current bond market yields are historically attractive enough to compete directly with stock returns so on a risk-adjusted basis it makes sense to invest in bonds too.
When the Fed stops tightening then historically it is time to buy Stocks, Long-term Bonds, and not Treasury-bills. Typically, Stocks and Bonds have outpaced Cash after a Fed hiking cycle ends based on research by Capital Group. After the Fed’s final hike in the last four cycles, both equity and fixed income returns produced above average annual returns in the year that followed. After Fed hikes ended, outperformance over cash lasted up to five years, with the first year contributing most returns. The study shows that the Bloomberg U.S. Aggregate Index rose 10.1% on average versus the index’s long-term average is 4.8%. The returns for the S&P 500 Index of 16.2% versus the index’s long-term average of 8.5%. A balanced portfolio of 60% S&P 500 Index/40% Bloomberg U.S. Aggregate Index blend retuned on average 14.2% compared to the blend’s long-term average of 7.4%. Whereas, the U.S. 3-month Treasury-bill retuned 4.7% for the year-after and its long-term average return is 3.2%.
With the Fed nearing the end of its tightening cycle, it’s time to invest more in cyclical growth stocks that may provide capital appreciation as the headwind of rate hikes ends. Sometime next year, the Fed is likely to cut rates marking the beginning of a recovery cycle. Also, dollar-cost-average into Long-term bonds offering attractive real yields and greater future price appreciation than Treasury Bills, and Intermediate bonds, when the Fed begins to ease monetary policy. Long-term quality bonds also protect your income investments from the reinvestment risks of short-term bonds. Adding Long-term bonds with higher yields should help dampen overall portfolio volatility when markets correct.
September was a horrible month for long term bonds with the 30-Years Treasury yield reaching a 23-year high and prices dropping approximately 8.5%. I think better times are ahead for long term bonds based on current real yields. The average for Bonds, as measured by the Bloomberg U.S. Aggregate Bond Total Return Index, for the 12-month period following month-end real yields above and below 1.5% have been positive according to Morningstar research. Real yields in bonds should attract investment flows in 2024 as inflationary pressure eases and rates remain higher for longer.
The so-called magnificent seven technology stocks (Nvidia, Microsoft, etc..) account for the majority of U.S. equity returns even with the current pullback in stocks at quarter end. I am sticking with quality stocks such as the magnificent seven even though their valuations demand its earnings growth to meet expectations in a slowdown. Many reasonably priced growth stocks are worth the bet because those stocks have what I want in a stock: sales growth, earnings growth, high profit margins, free cash flow, healthy balance sheets. Moreover, they benefit most from the AI investment thesis which is a secular tailwind for those companies. Quality technology stocks also fare well in a range-bound inflation environment and should also get a boost in valuation when the Fed eventually eases its key interest rate.
What else is worth buying? U.S. Small-cap stocks and U.S. Mid-cap stocks are trading at valuations below their ten-year average according to Morningstar. Earnings growth expectations are set much lower and it is easier to clear the bar. I am patiently dollar-cost averaging into U.S. Small-cap stocks while they trade at lower valuations. Small-cap stocks are more sensitive to changes in economic conditions. Many of them are more susceptible to tighter credit conditions that are associated with downturns so are under a cloud. Moreover, tighter credit makes it harder to refinance existing debt, adding risks. Small caps are discounting at least a slowdown. Small caps start outperforming when yields peak. I think yields will peak by year-end. Historically, highly economically sensitive Small-cap stocks lead in a recovery cycle.
Wall Street analysts project the S&P 500 Index to rise by 20% over the next 12 months according to FactSet. At the sector level, sectors that have been taken to the woodshed are expected to rebound strongly, namely Real Estate, Utilities, Consumer Discretionary, and Consumer Staples. Whereas the sectors that are leading now are expected to continue to fare well with very respectable low double-digit gains. I prefer Technology, Consumer Discretionary sectors that outperform in range bound inflation regime. Sectors with the worst returns also have the worse price to future earnings growth ratio (PEG) compared to the sectors I prefer. In layman’s terms investors are overpaying for future earnings growth in those trailing sectors. Sectors I’m investing in are still cheaper on a PEG basis than those that are underperforming this year. What could change my mind, an unexpected acceleration in earnings growth in those trailing sectors such as Real Estate, and Consumer Staples. Current extreme oversold conditions for Real Estate and Consumer Staples warrant selectively buying some inexpensive stocks in those sectors that have priced in slower growth ahead.
I also like energy stocks. The energy sector will profit from the re-industrialization of America theme. Energy companies have been underinvesting for years, and now structural supply shortages exist. OPEC forecasts rising global oil demand in an industry it says needs $14 trillion in investment to meet the growth. The energy sector is cheap and generates tremendous free cash flow used for dividends and has excellent balance sheets. The drawback to energy now is a strong dollar and higher interest rates for longer are a headwind, but that would change next year as yields fall followed by the US dollar.
When the Fed Funds Rate peaks it is time to invest in foreign developed markets equities. Generally, the U.S. dollar peaks as rates peak. The US dollar has treated from its high in early October. Again, Morningstar research points out that international equities, Developed Foreign Market Equities, measured by the MSCI EAFE Index, and Emerging Market equities by the MSCI EM Index, are both trading at a discount to their Ten-Year average multiple. I continue to add to developed foreign equities while prices are cheap. I remain underweight in Emerging market equities because of the geopolitical risks surrounding China. My strategy going forward is to buy emerging market equities ex China ETF. I have enough exposure to China in accounts through Apple and other multi-national companies.
I am adding duration to bond component of portfolio and only investing in investment grade bonds versus non-investment grade bonds. There is still credit risk as fundamentals could deteriorate under a higher for long-term interest rate regimes. What is more, if growth slows, high-quality bonds have tended to provide the important benefit of diversification from equities. If a recession does occur, more investors could turn to bonds in search of relative stability and income. Long term bond prices have risen during periods of slowing economic growth. Furthermore, credit spreads are narrow. The difference between investment-grade and high yield credit spreads are below its historical average according to State Street Global Advisors. This implies that non-investment grade credit is more expensive compared to investment grade. Therefore, invest in long term investment grade bonds.
Past results are not predictive of results in future periods. Sources: Capital Group, Morningstar. data represents the average returns across respective sector proxies in a forward extending window starting in the month of the last Fed hike in the last four transition cycles from 1995 to 2018 with data through 6/30/23. The 60/40 blend represents 60% S&P 500 Index and 40% Bloomberg U.S. Aggregate Index, rebalanced monthly. Long-term averages represented by the average five-year annualized rolling returns from 1995. Past results are not predictive of results in future periods. Data represents the average returns across respective sector proxies in a forward extending window starting in the month of the last Fed hike in the last four transition cycles from 1995 to 2018 with data through 6/30/23. The 60/40 blend represents 60% S&P 500 Index and 40% Bloomberg U.S. Aggregate Index. Long-term averages are represented by the average 5-year annualized rolling returns from 1995. Past results are not predictive of results in future periods. * For the three-month periods following the final hike, cumulative bond and stock returns outpaced 3-month T-bills by 3.1% and 2.1% and for six-month periods by 4.2% and 5.6% on average, respectively. While money market funds seek to maintain a net asset value of $1 per share, they are not guaranteed by the U.S. Federal government or any government agency. You could lose money by investing in money market funds. The market indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index. The S&P 500 Index is a market capitalization-weighted index based on the results of approximately 500 widely held common stocks. The S&P 500 is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Capital Group.
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